Saturday, March 25, 2006

The Experience Curve, Strategic Advantage, and the "Moat"

In The Intelligent Investor, Ben Graham famously said that "Investing is at its most intelligent, when it is most business-like." By which, I understand him to mean that investments should be selected in the same way that a business owner or manager makes business decisions, with regard to risk and return. Ironically (and contrary to Modern Portfolio Theory), companies that pursue the best strategies for their markets have both higher returns AND lower risk than average. As investors we must look to do the same.

The most important strategy for any business is to have the lowest relative cost in the product segments in which it competes. Having the lowest COST is not the same thing as having the LOWEST PRICE. In fact, in many cases, businesses can have both the lowest cost and highest price. Having the lowest cost means that a company has the most options in terms of attacking the market.

Immediately, one thinks of Wal*Mart: if a company has the lowest cost position, it can chose to be lowest price position as well, and ultimately crush competitors with low prices. Only the lowest cost producer has this option. If a higher cost producer has the lowest cost position, it is because the lowest cost producer is choosing to price higher (often at a premium). So let us consider that scenario.

If the company simply matches its competitors' prices, it will have the highest margins, and earn more per dollar of sales than its competitors. This is money that can be either reinvested in maintaining or improving that cost advantage, or in developing breakthrough products that allows the company to obtain a cost leadership (premium price) position. Or the company can return that money to shareholders through dividends or buybacks. Or it can do some of both. These companies (like Coca-Cola, Colgate-Palmolive and Philip Morris) are usually those that most reward shareholders. They can use their extra cash to reward shareholders.

How does one obtain that low-cost position? Well, if you listen to the news, they would suggest that one move all production to China, because they have the lowest labor costs. Actually, there is a much more consistent predictor of market success: market share. Companies with the highest market share should have the lowest relative cost. The reason for this is the Experience Curve, so-named by the Boston Consulting Group to describe a link they found between the number of times an operation is performed and the cost of that transaction.

They discovered that every time the volume of transactions doubles, the cost to perform that operation falls between 20 and 30 percent. Think about this idea: what it says is essentially that companies LEARN from repetition. Think about your day at work - if you do something over and over again, you tend to get faster at it, and spend less time, right? Since a company is an aggregation of individuals, the cumulative effect of all of this learning means lower cost! This is a different (but related) idea to economies of scale, which are what most news focuses on when it discusses mergers. Elimination of duplicate back-office functions and the like are definately cost position enhancers, and the ability to increase production volumes high enough to justify adding more capital are critical cost reducers, but it is critical to understand that a company with the highest market share will have more transactions, and will therefore learn faster (and have a lower cost position) than its compeitors.

What does this mean for investment strategy - we need to focus on business opportunities that have high returns and low risk. The best way to do that is to concentrate on businesses that are (or soon will be) leaders in their product segments. This does not, however, mean that we should only invest in large, mature companies (although this is often the right answer).

Jack Welch, upon becoming CEO of GE, said that GE must be 1 or 2 in every product segment in which it competes. The reason for this is the experience curve, which leaves just enough room for 2 competitors in most product categories. 3rd companies tend to get crushed during downturns (think Chrysler).

We must not, however, confuse the "largest company" with "high share". What is vital is how much share a company has in its product segments! GM, for decades the largest vehicle manufacturer in the world, has been one that has punished investors with low returns. How can this be? According to the experience curve, GM should have the best cost position and be able to dominate the market. This would be right, except that the auto industry has MANY products. GM dominates a few product segments (where it makes a large amount of money), but is an also-ran in many other segments in which it offers products. Mercedes-Benz, which hardly a volume manufacturer, makes much of its money from the S-Class, where it holds 50% of worldwide market share in that product segment. It therefore has the best relative cost (and because of its reputation, is able to charge a premium price).

When you look at an investment - ask yourself - will this company be a market leader today or in the future? If not, your best strategy is to sell.

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